Capital taxation in the 21st century

This article is a review and critique of the new book by Thomas Piketty, "Capital in the Twenty-First Century." Piketty, a professor at the Paris School of Economics, reviews data on income and wealth inequality in developed countries over the past hundred years or so. He makes bold projections that apparent recent trends of increasing inequality will continue and deepen. Based on his interpretation of the data, Piketty gives strong prescriptions to substantially increase marginal tax rates on income to institute a global tax on capital.

This article is a review and critique of the new book by Thomas Piketty, "Capital in the Twenty-First Century." Piketty, a professor at the Paris School of Economics, reviews data on income and wealth inequality in developed countries over the past hundred years or so. He makes bold projections that apparent recent trends of increasing inequality will continue and deepen. Based on his interpretation of the data, Piketty gives strong prescriptions to substantially increase marginal tax rates on income to institute a global tax on capital.

This article is a review and critique of the new book by Thomas Piketty,

Capital in the Twenty-FirstCentury

. Piketty, a professor at the Paris School of Economics, reviews data on income and wealthinequality in developed countries over the pasthundred years or so. He makes bold projections thatapparent recent trends of increasing inequality willcontinue and deepen. Based on his interpretation of the data, Piketty gives strong prescriptions to sub-stantially increase marginal tax rates on income andto institute a global tax on capital.The book’s political significance is high for

TaxNotes

readers because the Obama administrationearly on strongly endorsed Piketty’s claim withUniversity of California, Berkeley professor Em-manuel Saez that U.S. income and wage inequalityhas grown significantly over the last 30 years. Theadministration highlighted Piketty’s findings in itsfirst proposed budget, presented in 2009, tyingmajor parts of President Obama’s domestic policyagenda to the research. More recently, Obama hasstated that inequality is the single most importantpolicy issue in the United States, ‘‘the definingchallenge of our time.’’ The book will also surelyresonate in Europe and among international eco-nomic organizations. The book’s intellectual signifi-cance is high for

Tax Notes

readers because thestatistics reported are based mainly on historicaland recent tax records for France, Great Britain, andthe United States (and to lesser extents, Germany,Sweden, and other countries).

Economic Theory

Piketty organizes his analysis around two simpleequations that he calls fundamental laws of capital-ism. The first is an accounting definition — theshare of capital in national income equals the prod-uct of the return on capital and the capital/incomeratio. While tautological, the equation is nonethe-less informative because it expresses an importantrelationship among key variables, each of whichcan be measured and explained, sometimes inde-pendently and often by various data sources. Forexample, if the capital/income ratio is 600 percentand the return is 5 percent, the share of capital innational income is 30 percent. Capital is definedand measured as all forms of real property (includ-ing housing) and financial and professional capital(plants, infrastructure, machinery, inventory, pat-ents, and so on) used by companies and govern-ment, all of which can be owned and exchanged, onsome market. Thus, capital is largely measured atmarket prices.The second equation, or fundamental law of capitalism, is that the capital/income ratio is equalin the long run to the savings rate divided by theeconomic growth rate in inflation-adjusted terms.For example, if the savings rate is 10 percent and thegrowth rate is 2 percent, in the long run the capital/income ratio must be 500 percent.While these equations are elementary concepts inthe theories of economic growth and development,their relevance to the study of inequality is that theownership of capital is often concentrated among arelatively small group of the population. Hence, thestudy of the path of capital is considered essential tothe study of inequality. Moreover, labor income can be unequally distributed as well. Finally — andthese are key points — Piketty believes that thereturn on capital has held fairly steady over timeand will continue to do so, while the rate of economic growth declines as the population (that is,labor force) stops increasing and even decreases inmany European and Asian countries. Piketty alsothinks that the savings rate is fairly steady, regard-less of changes in economic conditions, because it ismainly influenced by the desire of the rich to leave bequests to their children. As we will see, these beliefs lead to a strong prediction of an increasingrole for capital in the future, and therefore moreinequality arising from bequests, which Pikettyviews negatively.

Capital Ratios and Income Factor Shares

Measuring the capital/income ratio over threecenturies, Piketty finds that through 1910, the ratioin both Great Britain and France was steady at

Mark J. Warshawsky was formerly Treasuryassistant secretary of economic policy and is avisiting scholar at the Mercatus Center at GeorgeMason University.Thomas Piketty,

about 700 percent and then plummeted in theaftermath of World War I to about 300 percent. Thecapital/income ratio remained at that low level,even declining a bit, until 1950, when it began aclimb, reaching 500 percent in Britain and 600percent in France by 2010. Looking at componentparts, one finds that at least part of the plunge in1920 resulted from the expenditure of significantnet foreign capital to pay for the war, and at leastpart of the recent rise is the result of substantialincreases in housing. In Germany, the trajectory islargely the same except that the fall after World WarI continued through 1950 as physical capital wasdestroyed in World War II, so that the capital/income ratio was only about 200 percent then. Thelater increase is significant but to a lower level, justmore than 400 percent in 2010, again largely be-cause of housing assets.By contrast, for the United States, the capital/income ratio increased steadily from about 300percent in 1770 to 500 percent in 1910, falling onlyslightly after World War I and increasing againthrough 1930 with the stock market boom. The ratiofell to below 400 percent by 1950 and, thereafter,increased only slightly through 2010 to about 430percent. Interestingly, the run-up in housing prices,although present in the United States, is much lesspronounced than in France, Piketty found

,

usingdecade average statistics, although the short-termdrop for the United States from 550 percent in 2007to 430 percent in 2010 surely reflects the volatility of both the housing and stock markets. Incomegrowth, partly the result of rapid populationgrowth from immigration, is also higher in theUnited States than in Europe, which increases thedenominator and therefore lowers the long-runcapital/income ratio.Piketty collects similar data for other countries —Canada, Japan, Australia, and Italy — althoughgenerally for shorter periods. He finds a massiverun-up of Japan’s capital/income ratio, from about360 percent in 1970 to 800 percent in 1990, followed by a rapid decline to 700 percent after the asset bubble popped in the country, and a further de-crease to about 600 percent in 2010. For Italy, he seesa steady and rapid increase from just about 250percent to 600 percent over that same period.Piketty explains the overall increases in those coun-tries’ ratios by the second fundamental law of capitalism: low economic growth and high savingsrates.From this and other scattered data, Piketty makessome truly bold assumptions and takes two gigan-tic leaps. He creates a world capital/income ratiofrom 1870 to 2010 and then projects that ratiothrough 2100. While some would view that exerciseas almost a work of fiction, Piketty is serious aboutthe results. He says that the world ratio was 500percent in 1910, dropped to 260 percent in 1950, andthen increased to about 440 percent by 2010. There-after, it is projected to continue to increase to 600percent by 2060 and to 670 percent by 2100. Onemust credit Piketty for taking a global view becausecapital markets have indeed become open andlinked in most countries. The simplicity of using thesecond equation and assuming in the long run anaverage world savings rate of 10 percent and aneconomic growth rate of 1.5 percent to project theglobal capital/income ratio is breathtaking, how-ever.Piketty next moves from the capital/income ratioto the share of capital income in total nationalincome, using the first fundamental law of capital-ism. He shows that there has been an overalldownward trend for Britain and France, from about40 percent in the 19th century to about 20 to 25percent or even less in most of the 20th century,increasing recently to about 25 percent or a bithigher. Piketty attributes most of this trend to thechanges in the capital/income ratio over time, buthe allows for some changes in the rate of return aswell, with return increases in the mid-20th centuryand declines most recently. Looking over a shorter,more recent period, Piketty finds that the capitalshare in the United States increased from 21 percentin 1975 to 29 percent in 2010, with considerablevolatility in between, apparently related to the stockmarket. With the exception of Canada, the otherdeveloped countries saw similar share increases forcapital over that period.Despite recent lows in interest rates, Piketty saysthat the total rate of return on capital, averagingacross risk types, is still and generally will be about4 to 5 percent in inflation-adjusted terms. Theserates have changed little from the rates of return onagricultural land and government bonds implicit in Jane Austen’s depiction of Mr. Darcy’s estate in-come or in Honoré de Balzac’s description of thedowries of Père Goriot’s daughters in the 1810s. So,according to Piketty, while rates of return may fallsomewhat as capital increases, most of the projectedincrease in the capital/income ratio will flowthrough to the capital share of income. In moretechnical terms, this indicates that the elasticity of substitution between capital and labor exceeds 1, acontroversial claim.Piketty concludes this section of the book byprojecting that with a capital/income ratio of 700 to800 percent and a rate of return of 4 to 5 percent,capital’s share in national income will increase to 30to 40 percent — levels close to those of the in-egalitarian inheritance-influenced days of Austenand Balzac. Again, these projection calculations areextremely rough and, indeed, seem exaggerated,

but Piketty uses them to advance his central argu-ment that income inequality arising from the in-creasing role of capital in an environment of economic stagnation is growing and will continueto do so, with little in the way of natural checksexcept for government intervention.

Inequality

The main way Piketty measures inequality,whether of income, labor earnings, or capital own-ership, is to calculate the share of various toppercentiles of the population in the quantity inquestion (income, etc.) for various countries andperiods. For example, he reports that the top per-centile in Scandinavia in the 1970s and 1980s got 5percent of total labor income, while the next 9percent got 15 percent. For the same region andperiod, capital ownership was more concentrated,with the top percentile owning 20 percent and thenext 9 percent owning 30 percent. These data are based mostly on annual observations, either fromtax records or surveys, and there is no assurancethat they represent the same people or families overlong periods (even generations), particularly if there is a lot of mobility and volatility in the societyand economy. Nonetheless, Piketty calls the top 1percent the dominant class, the next 9 percent thewell-to-do class, the middle 40 percent the middleclass, and the bottom 50 percent the lower class.These clearly are arbitrary categories that may ormay not correspond to recognizable social andpolitical groupings, such as British nobility in the1820s.As is usual in

Capital

, Piketty starts with andconcentrates his review of data in France. The upperdecile’s share of national income decreased from 40to 50 percent in the 1910s to mid-1930s to 30 to 35percent today. Almost the entire drop occurred just before and during World War II. By contrast, thewage share has been fairly flat over the entirecentury, at about 25 percent of total labor income.The collapse in income for the top percentile startedearlier, after World War I, and was more dramatic —from 20 percent in 1910 to 8 percent by 1945 andincreasing slightly to 9 percent by 2010 — while topwage shares are remarkably stable, at 6 percent over100 years. Piketty also shows that the share of income of the top 0.5 percent coming from capitaland labor inverted between 1932 and 2005. He callsthese trends the fall of the

rentier

and the rise of asociety of managers. Note, however, that those dataexclude capital gains.Piketty then presents comparable data for theUnited States. The share of the top decile in totalincome was about 40 percent in the 1910s, it in-creased to 45 percent in the 1920s-1930s, plummetedto just above 30 percent during the years of WorldWar II, remained at that level through 1980, andclimbed back to 45 percent by 2010. If capital gainsare included, the levels are somewhat higher onaverage and far more volatile. Piketty attributesmuch of the plunge in income inequality duringWorld War II to the activity of the federal govern-ment in restricting wage increases. Given his ulti-mate focus on tax policy, it is surprising that heignores the potentially more significant changes intax law and administration during the war.Piketty provides data showing that most of theincrease in income inequality in the United Statesfrom the mid-1980s forward is attributable to thetop percentile, some of it to the top 1 to 5 percentand almost nothing to the top 5 to 10 percent.Indeed, in 1986 the share of the top percentile intotal income was 9 percent. It jumped to 13 percentin 1988 after passage of the Tax Reform Act of 1986,followed the path of asset markets up and downthereafter, and by 2010 increased to 17 percent.Further, Piketty finds that regarding labor incomedata, about two-thirds of the increase in incomeinequality is attributable to the rise of wage inequal-ity, which he attributes to the advent of ‘‘superman-agers.’’ Note that wages include all bonuses andstock options.Looking at other countries, Piketty finds thatincreases in income inequality are generally similarto those in the United States but smaller. In theUnited Kingdom, the top percentile share increasedfrom 7 percent in 1981 to 15 percent in 2010. Overthe same period, the share increased from 5 percentto 9 percent in Australia, 8 percent to 12 percent inCanada, 4 percent to 7 percent in Sweden, 7 percentto 10 percent in Japan, and 9 percent to 11 percent inGermany.Note that despite a large increase in the capital/income ratio in France, the increase in incomeinequality there was the smallest among the devel-oped countries surveyed. By contrast, the increasesin reported income inequality were large in theUnited States and the United Kingdom, while thecapital/income ratio remained flat in the UnitedStates and increased in the United Kingdom, but toa lesser extent than in France. Those observationsare inconsistent with Piketty’s central point that weshould be concerned about the growth of capitaland tax it heavily because of the dire implications of income inequality.Piketty then turns to the inequality of capitalownership. He finds that in France the top decileowned 90 percent of capital in 1910 but that thatshare dropped steadily to 60 percent in 1970 andthereafter remained constant. According to Piketty,a similar pattern and levels may be found for theUnited Kingdom and Sweden, although there weresmall increases after 1980. For the United States, theheight in the ownership of capital by the top decile